What Does Cash Free Debt Free Mean in M&As?

A cash-free, debt-free transaction means the buyer acquires a company based on its core operational value, without considering the company’s cash reserves or debts. The idea is that the seller should remove all excess cash and settles all debts before completion, simplifying the valuation and focusing solely on the business’s operational worth. This article will explain what does cash free debt free mean, how these transactions work, and their benefits in mergers and acquisitions.

Key Takeaways

• In a cash-free debt-free transaction, buyers pay solely for the core operations of the company, as sellers are required to remove excess cash and settle debts before completion.

• Clear definitions of cash and debt are critical in these transactions, ensuring both parties agree on what constitutes excess cash and liabilities, which streamlines the process and mitigates disputes.

• Other related adjustments to the purchase price based on completion accounts and methods like Net Asset Value and Locked Box provide frameworks that reflect the company’s true financial position, ensuring a fair transaction.

Understanding Cash Free Debt Free Transactions

In a cash-free, debt-free transaction, the buyer pays only for the core operations of the target company, as reflected in the enterprise value. This approach means that the seller must remove all excess cash and settle all debts before the deal is completed. Structuring the transaction on a debt-free basis allows both parties to concentrate on the business’s core value without the complexities of existing debt and cash reserves.

The purchase price in such transactions is aligned with the enterprise value, which simplifies the valuation process significantly. Instead of negotiating over the fluctuating amounts of cash and debt, the focus shifts to the operational value of the company. This makes it easier for both buyers and sellers to agree on a fair price, as cash assets increase the purchase price while debt items decrease it. Additionally, parties may consider how to purchase equity value in the overall deal structure.

This method of structuring a business purchase ensures that the buyer is not overpaying for excess cash or underpaying due to liabilities. Essentially, cash-free, debt-free transactions provide a clear and transparent foundation for M&A deals, making them a preferred choice in the corporate world.

Defining Cash in Cash Free Debt Free Deals

Understanding what constitutes cash in a CFDF deal is crucial for both parties. The definition of cash extends beyond just the money in the bank; it includes assets that can be quickly converted into cash, such as petty cash and credit card payments in transit. This broader definition ensures that all liquid assets are accounted for, providing a comprehensive view of the target company’s cash position.

Typically, cash balances in these deals include bank cash, petty cash, and credit card payments in transit. Excess cash is defined as any funds beyond the target company’s cash figure agreed upon by the parties. This excess cash is usually extracted before the deal closes, ensuring that the buyer is not paying for funds that are not necessary for the ongoing operations of the business.

A Share Purchase Agreement (SPA) usually defines cash as

“the aggregate amount of all (a) cash on hand; and (b) cash standing to the credit of any account with a bank or other financial institution“.

Identifying Debt in Cash Free Debt Free Transactions

Just as defining cash is essential, identifying what counts as debt is equally critical in CFDF transactions. The seller is responsible for settling all outstanding debts before the transaction is closed. This includes not just traditional liabilities but also debt-like items such as outstanding tax liabilities and certain financial instruments. Trade debt is usually excluded, the focus remains on more traditional forms of financing.

The SPA can be negotiated to reflect the understanding of the parties, including what they deem should be recognised as cash and debt. This flexibility allows both parties to agree on the specific items that will be included or excluded, ensuring a smooth transaction process.

In an SPA, indebtedness (debt) is usually defined as:

“the aggregate amount of their respective borrowings and other financial indebtedness in the nature of borrowing including (without double counting):

1a)           borrowings from any bank, financial institution or other entity;

1b)           indebtedness arising under any bond, note, loan stock, debenture, commercial paper or similar instrument;

1c)           obligations under any conditional sale, title retention, forward sale or purchase or any similar agreement or arrangement creating obligations with respect to the deferred purchase price of property (other than customary trade credit given in the ordinary course of trading);

1d)           indebtedness under any hire purchase agreement or finance lease (whether for land, machinery, equipment or otherwise) which is a liability under accounting [standards FRS 102];

1e)           any indebtedness for monies borrowed or raised under any other transaction that has the commercial effect of borrowing;

1f)            any preference shares or element of preference shares shown as liabilities as required by applicable accounting standards;

all unpaid accrued interest on any borrowings or indebtedness referred to in the paragraphs above, together with any prepayment premiums or other penalties, fees, expenses or breakage costs arising (or which would arise) in connection with the repayment of any such borrowings or indebtedness.“

The Role of Completion Accounts

Completion accounts play a pivotal role in CFDF transactions. These accounts provide a financial snapshot of the target company’s status at the time the transaction concludes. They are crucial for assessing any excess cash left in the target or identifying debts post-completion.

Unlike statutory financial statements, the preparation of completion accounts is not governed by specific laws but relies on mutual agreement between the parties. Accountants experienced in M&As are essential for properly preparing and negotiating these accounts.

Completion accounts frequently result in purchase price adjustments based on the actual cash, debt, and working capital at closure, ensuring the final price reflects the company’s true financial position.

Real-World Example with Figures

To illustrate the CFDF concept, let’s consider a hypothetical example. Assume a company with an enterprise value of £1 million, £100k in excess cash above the required working capital, and £50k in liabilities.

There are two main potential outcomes:

1. The seller uses £50k of the £100k in cash to pay off the £50k in liabilities. This leaves £50k in excess cash, which they extract in their preferred way (e.g., as a repayment by the company of a loan owed by the company to the seller).

2. The seller leaves the business as is, meaning with £100k in excess cash and £50k in liabilities. The buyer must now pay the seller: £1 million PLUS £100k in excess cash MINUS £50k in liabilities, which = £1,050,000.00.

Adjustments to Purchase Price

Adjustments to the purchase price are a critical component of CFDF transactions. Completion accounts determine the actual cash, debt, and working capital positions at the time of completion, directly impacting these adjustments. Buyers prefer that excess cash be extracted from a business before completion to avoid paying extra for it in the purchase price.

Essentially, if there is more cash and/or less debt than expected, then the deferred payments are increased (effectively increasing the purchase price). On the other hand, if there is less cash and/or more debt, then the deferred payments are decreased (effectively decreasing the purchase price).

Aligning the final purchase price with completion accounts allows both parties to achieve a transaction that accurately reflects the company’s value, minimising disputes and ensuring a smoother transition.

Net Asset Value (NAV) vs. Cash Free Debt Free

An alternative to CFDF is structuring the purchase according to the Net Asset Value (NAV). The NAV serves as a benchmark for adjusting the purchase price based on the company’s actual financial position at completion.